It’s the iconic American industry. But audiences are vanishing, piracy is soaring, and new technology is treacherous. Can Tinseltown innovate its way out of trouble?

By Alan Deutschmanlong Read

“You can take Hollywood for granted like I did, or you can dismiss it with the contempt we reserve for what we don’t understand. It can be understood, too, but only dimly and in flashes. Not half a dozen men have ever been able to keep the whole equation of pictures in their heads.”

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So says Cecelia Brady, the daughter of a Hollywood mogul in The Last Tycoon, the book F. Scott Fitzgerald left unfinished when he died near Sunset Boulevard in 1940. It’s the most famous passage ever written about the business of Hollywood. And it’s poetic–but not entirely accurate. It’s not that only a few have ever been able to comprehend Hollywood; only a few have ever run it.

In both the Old Hollywood of the ’20s, ’30s, and ’40s, as invented by rags-to-riches Eastern European Jewish immigrants, and the New Hollywood of our day, recast by the CEOs of global conglomerates–Disney, General Electric, News Corp., Sony, Time Warner, and Viacom–hardly more than a handful of moguls at any time have controlled the preeminent forms of entertainment: film and television. They’ve determined how movies and shows are created, and dictated when, where, and how we can consume them. Want to see a new movie? You have to line up at the multiplex for its 7:15 or 9:30 show, or wait for months until you can buy the DVD or see it on cable. Like a TV show? It airs only on Tuesdays at 8.

That’s over, or will be soon: In the New New Hollywood of the digital era, no one will be in control–except, in a way, all of us will be. The oligarchy of the moguls is falling to the democracy of the consumers. A small cadre of corporate chiefs could control the cinemas, the airwaves, and the shelf space in the DVD aisles at Blockbuster and Wal-Mart, but no one can control the Internet. Transmitting video files to consumers over digital broadband connections–whether via cable, phone, satellite, or wireless Wi-Max–changes the whole equation. We’ll have smart ways to search for, grab, view, store, organize, and replay what we want–and, often, to modify and share it. We’ll get it when, how, and where we want, whether we’re watching in our home theaters or on laptops or handheld devices. For the price of taking a family to the movies–plus popcorn and soda–tomorrow we’ll buy digital gizmos that can hold and organize thousands of hours of video. We’ll be the ones who determine what advertising we’ll interact with and when and how. We’ll create and disseminate our own video entertainment rather than just consume it. And more artists will be able to give us what appeals to our specific interests rather than to the lowest common denominators of society.

These trends are already well under way, and they’ll play out fully over the next 5 to 10 years. They’ll create extraordinary opportunities for innovative new players–and for the establishment powers, if they can survive the transition. “There’s no question we are searching,” says Kevin Tsujihara, president of Warner Bros. Home Entertainment Group. “We are searching for the new platform or the new channel that will drive the profits in the future, but there are so many unknowns . . . What we do know is that the entire model is up for grabs.”

The curtain is rising on Hollywood’s “third act,” and the drama is most stunning when you briefly recall the plot points of the first two. In the Old Hollywood of the ’20s through the ’40s, the seven studios–Columbia, MGM, Paramount, RKO, 20th Century Fox, Warner Bros., and Universal–exerted awesome control over talent as well as movie theaters. Every week, about two-thirds of all Americans went out to the movies to see . . . well, whatever was playing at the neighborhood movie house. Because the moguls tightly controlled the costs of making films, and since they hardly had to spend on advertising, nearly every release made money, according to Edward Jay Epstein’s recent book, The Big Picture.

The Old Hollywood system fell apart in the ’50s when the studios were forced to divest the movie houses and let the stars become free agents. The studios’ fall was accelerated by the rapid and inexorable rise of television, which decimated the moviegoing audience. But eventually a new Hollywood emerged, and it was as brilliant and astonishing an invention as the original. While RKO didn’t survive, the other six major studios were absorbed into six global media-entertainment conglomerates that combined them with TV and cable networks, cable and satellite connections, and video-rental stores. Now, according to Epstein, the oligarchs have a 96% market share of the box-office take. They collect 98% of the national prime-time television advertising dollars. And they have 80% of the subscribers to pay-TV services, including Cinemax, HBO, and Showtime.

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The big studios effectively control distribution, which suits the cinema owners just fine (they know studios will spend heavily to advertise to get people off the couch and into the multiplex). So if you’re a filmmaker and want to reach a fairly large audience and make some real money, you simply have to get a major studio as your distributor–which means giving the studio the copyright, too.

This system has been imploding for two reasons. First, it depends on mobilizing a mass audience through mass marketing, and that’s a daunting task these days. It’s extremely hard, and extremely costly to reach an audience fragmented by the countless options offered by cable networks, the Web, video games, and home video. That’s particularly true since with each film, the studios “have to create a brand from nothing, and they don’t have a lot of time to do it,” says Nicholas Donatiello of Odyssey, a consultant to media and entertainment companies. (No wonder Hollywood prefers to make sequels, or buy the rights to established brands, such as Harry Potter, or fork over as much as 30% of the gross to stars such as Tom Cruise, who are their own brands.)

Second, nearly every movie loses money on its theatrical run these days. Studios typically pay as much to advertise a movie’s cinematic release as they spent making the movie to begin with. They’re stuck betting that much because a big-screen opening is essentially an expensive form of promotion–not only to the consumers who’ll buy or rent the DVD but also to “the industry.” The opening helps determine how much the studios can get for licensing the movie for pay TV, cable, and overseas. The theatrical release has become a loss leader to promote the studios’ real moneymaker, the DVD, which in turn often serves as a loss leader for Wal-Mart to draw in shoppers.

Talk about a badly convoluted system. Hollywood’s moguls know they’re in big trouble when the single most powerful person in the industry today is Wal-Mart CEO H. Lee Scott Jr. Don’t you think DreamWorks Animation CEO Jeffrey Katzenberg would rather hang out at a beach house in Malibu with Steven Spielberg than schlep to Bentonville, Arkansas, for the retailer’s Saturday-morning management meetings? But schlep to Bentonville he does–often, actually–and he even wears a blue Wal-Mart apron when he’s there.

If today’s problem for the studio moguls is that they’re captives of Wal-Mart, then tomorrow’s will come when they’re challenged by the likes of Google, which has declared itself a “media company,” and Yahoo, which is paying $100 million to take over the huge former MGM headquarters in Santa Monica, California, as offices for 1,000 employees in its Hollywood division. Yahoo’s operation is being run by Lloyd Braun, a former ABC executive who helped oversee the creation of Desperate Housewives. His mission is to create original, interactive programming that reinvents news and entertainment for a new medium. He has already hired his own roving war correspondent, Kevin Sites, and set up an “adventure” channel on which mountain climbers, for example, will post their own videos.

The Internet’s immediate threats to the Hollywood oligarchy are piracy, which costs the industry some $5.4 billion a year, and competition, in the form of digital blandishments that are drawing more and more people out of movie theaters. (Box-office admissions fell some 12% this past summer; the defections were even more dire among the movies’ prime market: young males.) But the real threat is how the digital lifestyle has radically changed consumers’ expectations. What we have learned from the first decade of the digital era is that we’re the ones who will be in control of when, where, and how we consume media. Give us cell phones, and we’ll tear out our landlines. Give us laptops, and we’ll chuck our desktops. Give us Wi-Fi, and we’ll take our laptops everywhere. Give us BlackBerrys, and we’ll leave our laptops at home. Let us download music, and we’ll never go to the store to buy CDs. Give us VCRs and TiVo, and we’ll watch TV shows whenever we want–and zap the commercials. Give us the news as it happens, and we won’t look at tomorrow’s papers.

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Hollywood’s movie and TV businesses are the last part of the media-entertainment complex to confront this empowered digital consumer. That’s because good-quality video takes up so many more bytes than text, graphics, and music–making it slower to transmit and harder to store. To date, the digital boom has mainly benefited Hollywood: Many of the top-grossing films of recent years have either been digitally animated (Shrek 2, Finding Nemo) or relied heavily on digital special effects (the Lord of the Rings trilogy, the Star Wars prequels). And high-definition digital production is letting filmmakers such as Robert Rodriguez and Steven Soderbergh create movies for a fraction of traditional budgets.

The new technology also expands what’s possible. Without it, Rodriguez says he couldn’t have even conceived of his 3-D movies such as Spy Kids 3-D or The Adventures of Sharkboy and Lavagirl. “When you take the technology and mix it with art, you always come up with something innovative,” he says. “That won’t come from the studios, because they are so reactive.”

But now the industry is recognizing the full scope of what lies ahead. For one thing, peer-to-peer technology is making it possible to pull DVD-quality movies off the Web in minutes (see “Peer-to-Peer: The Problem Is the Solution“). And the music business offers the movie moguls two lessons: If you don’t let us buy what we want, when we want it, we’ll take it anyway. But if you make it affordable and easy enough for us to get what we want–as Apple’s Steve Jobs did with iTunes and the iPod–then we’ll happily pay you and make you a star. “The opportunities arise out of our philosophical view of these disruptions,” says Mitch Singer, executive vice president of Sony Pictures Entertainment’s Digital Policy Group. “Once we have perceived these technologies as enabling, rather than as violations of this code or this part of the copyright law, then we can start looking at ways to reach the consumer more effectively.”

In Silicon Valley, smart strategy has long depended on an ability to answer the question, Is this a bug or a feature? That’s what movie moguls need to learn as Hollywood rules are supplanted by Internet rules. Is it a bug . . . or a feature? If we could get the films we want legally, and cheaply enough, then why bother stealing them? Why can’t Hollywood let us see new movies on our terms–at the theater, on DVD, or streamed or downloaded to our home theaters or laptops or handheld devices?

That battle is beginning now, and it’s already getting hot. All the players have powerful interests in protecting their so-called “windows”–the number of weeks when they can sell their version of the movie before the next player in line gets the rights to sell it–but entrepreneurs have started hurling rocks through those windows. The tech billionaire Mark Cuban, who owns an independent film distributor, Magnolia Pictures, plans to sell DVDs of Soderbergh’s coming films on the same days they open in the 60-screen indie cinema chain Cuban also owns (see “Maverick Mogul“). In October, Cablevision’s Rainbow Media revealed that it hopes to release 18 to 24 films a year simultaneously to video-on-demand cable, DVD, and its own IFC cinema in New York’s Greenwich Village. And Rainbow has a close partnership with Harvey and Bob Weinstein, the impresarios who catalyzed the indie-film boom at Miramax. Cuban and his partner Todd Wagner are investors in Harvey and Bob’s new studio, the Weinstein Co. Even Oscar-winner Morgan Freeman is getting into the act, teaming up with Intel to offer movies by broadband connection at the same time they’re released in theaters.

Disney’s new chief, Bob Iger, has terrified the Hollywood establishment by talking openly about breaking some glass. Shortly before taking over as CEO on October 1, Iger told Wall Street analysts, “I don’t think it’s out of the question that a DVD can be released in effect in the same window as a theatrical release, although I’m sure we will get a fair amount of push-back from the industry. I think that all the old rules should be called into question, because the rules, in terms of consumption, have changed so dramatically.” A couple of months earlier, he told a media conference that he would “not allow management of traditional businesses to get in the way of very, very important migration to new media platforms. The competition will get the best of us if we don’t move in that direction.”

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Who will be the big winners in the New New Hollywood? Judging by the past decade of the digital boom, they will be companies that help us search the vast array of digital content that’s out there, find what we want, buy it when it’s for sale, and get it onto our screens and hard drives. In the past 10 years those companies included the likes of Google and Yahoo. In the coming 5 to 10 years, they’ll include . . . Google and Yahoo, which are already popular sites for downloading video. The winners may also include video-on-demand providers such as Comcast, which has taken the lead in VOD and brought the service to millions.

The oligarchy will lose its tight control of the industry, but that doesn’t mean that those six global conglomerates won’t be winners if they’re shrewd and nimble. Iger, for one, is pushing to move lots of Disney’s content from TV and movies into new media.

Still, as theatrical openings lose their place as the key variable in the “whole equation,” the studios’ stranglehold will give way to a period of chaos and creativity. A great deal still needs to be sorted out, such as how people will get paid for the use of their intellectual property. But this period of ferment will ultimately lead to a lot more choices for us–and a chance for real innovators to seize the future.